Despite it being the height of the holiday season, central bankers at the ECB found the time to issue a newsletter on 14 August calling on banks supervised under the Single Supervisory Mechanism (SSM) to step up their Brexit preparations. This seems to have been driven by a perception that banks had been "easing off" on preparations, especially, since the April extension to Article 50. With the new UK government apparently sticking firmly to its policy of leaving the EU on 31 October, there is a renewed sense of urgency.
The ECB's newsletter reiterates the positions previously expressed by the ECB regarding its expectations as to the level of substance required to be created and maintained within the territory of the EU-27, its approach to outsourcing, remote and back-to-back booking models, and related matters. The ECB also emphasises its view that banks should use the remaining time before 31 October to make sure they are fully prepared - in particular, that boards should step up their preparations to complete their target operating models and, where applicable, fulfil their commitments to the ECB to build up local risk management capabilities and governance structures in the EU-27.
The latest in a series of announcements
This newsletter is the latest publication by EU institutions on preparations by banks for Brexit. In October 2017, the European Banking Authority published a set of key principles on internal governance, outsourcing, risk transfer and “empty shells” in its opinion on issues related to Brexit. This was followed in February 2018, by the European Commission's notice to stakeholders on the consequences of the UK becoming a third country in respect of banking and payment services. In addition to regularly updated FAQs, in August 2018, to provide clarification to the sector, the ECB published its supervisory expectations on “empty shells” and booking models - a key battleground on how much of their operations banks should move from the City of London to EU-27 financial centres.
Transfer of activities, critical functions and staff has been less than expected
Since Article 50 was triggered, the EU has generally taken a robust stance on issues relating to EU substance, pushing back on perceived attempts by UK-based banks (including international entities whose European headquarters are in the City of London) to put in place work-arounds to mitigate against the loss of passporting and status as EU authorised entities. Broadly speaking, the EU has pursued a policy of relocation from the City to the EU-27 and has sought to limit the use of "empty shells" as well as insisting on strict controls and limitations in relation to remote booking and back-to-back booking models.
Much planning and preparation has, of course, already taken place. Global banks with European headquarters in London have established new entities in Paris, Frankfurt and Ireland and have been in the process of recruiting staff in their EU locations (or relocating certain staff). Although, the ECB is now stating publicly its confidence that a no-deal Brexit will not unduly impact financial stability, it wants banks to continue preparing for all possible contingencies. However, the ECB appears to be concerned that, to date, substantially fewer activities, critical functions and staff have been transferred to EU-27 based entities than it originally expected.
The ECB is indicating that while it has taken a flexible approach to date in allowing banks time to build up their capabilities within the EU-27, it intends to follow up with banks on commitments that they have made in relation to these issues, and to track their progress in establishing target operating models. This work is likely to be included in the normal ECB Supervisory Review and Evaluation Process (or SREP).
Areas where the ECB expects banks to speed up preparations
The ECB says it specifically wants to see banks step up their preparations to:
- minimise or manage execution risk. A recent AFME report on remaining no-deal risks in financial services highlighted concerns over conflicting EU and UK Share Trading Obligations in the absence of equivalence decisions over trading venues. Similarly, over the risk of disruption to markets because of overlapping and contradictory derivatives trading obligations;
- address operational challenges associated with transferring staff and clients and setting up the internal processes and systems to ensure full implementation of target operating models within agreed timelines;
- prepare for differences in the application of prudential provisions under the Capital Requirements Regulation and Capital Requirements Directive (CRD IV), in EU-27 countries compared to the UK as a third country, especially as regards UK-linked exposures or assets. For example, the treatment of UK-related exposures may change;
- implement effective mitigation regarding customers and contractual arrangements, such as engaging with customers and entering into novations, with respect to the continuity of uncleared cross-border derivatives contracts. While both the UK and EU-27 have put in place contingency measures, the ECB points to their temporary nature and that they do not replicate passporting rights; and
- ensure sufficient EU-27 capacity (i.e. excluding group entities or branches in the UK) to originate business and access key financial market infrastructures (FMIs). In respect to the latter, banks should consider what alternative FMIs (in the EU-27) would be available if access to existing infrastructure is not possible or there are questions over settlement finality.
"Adjustments" to "back-branching" and back to back transactions
In addition to calling on banks to step up preparations for Brexit as described above, the ECB flags up a number of areas where it says its supervisory expectations have not been met. These include the controversial areas of "back-branching" and remote booking practices with back to back hedging. The former concerns the servicing of EU-27 customers from UK branches of EU banks post-Brexit. As a matter of law, as a branch (unlike a subsidiary) is the same legal entity as its licensed head office, there is not the same legal prohibition on a branch continuing to perform services on behalf of customers in the EU-27. However, as a practical matter, the attitude of regulators is crucial. The ECB has repeatedly expressed its view that the purpose of branches in third countries should be to meet local needs rather than providing services back to customers based in the EU-27 (though that view does seem at odds with how many global banks in fact operate and how they have operated for a prolonged period of time).
The ECB's previously issued FAQs have said that banks need to be in a position to "clarify" the role of such branches and provide supervisors with detailed information on their activities. The August newsletter, in fact, goes a step further stating that entities should "adjust" (i.e. cut back) on this practice. The ECB has already said that it will review on a case-by-case basis its decisions this Spring authorising euro-zone banks to retain branches in the UK post-Brexit. The legal justification for such an approach, and whether it is required by or is consistent with EU law, can certainly be debated but the practical reality is that the ECB is in a position to exert significant leverage over SSM in-scope firms who want to obtain or retain their EU licences.
The ECB continues to press banks to curtail the use of back-to-back transactions, promising to monitor closely their booking policies. The FAQs emphasise that banks must have sufficient capabilities (e.g., local infrastructure, staff and risk management functions) to manage all material risks locally and, specifically, for back-to-back, that part of the risk generated is managed and controlled locally. The ECB also expects firms to have contingency plans that enable risks being overseen in third countries to be on-shored in certain circumstances, for example, where the third country branch or affiliate is in financial difficulty.
A new emerging regulatory landscape
The contours of the post-Brexit landscape from an ECB and SSM perspective are therefore emerging ever more clearly, and banks can expect continuing scrutiny of their contingency planning this autumn. It is probably a safe assumption that national regulators who supervise firms outside the SSM will also be influenced by the ECB's approach, particularly given the similarity of some of the EBA's statements on these issues. Banks will need to ensure that their target operating models are calibrated carefully and can be justified while bearing in mind that the ECB is likely to push for their reliance on UK operations to be curtailed.